Description

Note- I've uploaded a pdf that includes charts and tables that back up the investment thesis. While I've modified the write up below so it flows without them, seeing the charts and tables will back the points up and makes the thesis much more compelling, so I encourage you to read that version.

At $14-ish per share, USA Truck (USAK) is a materially undervalued trucking company in the midst of a successful turnaround. With multiple catalysts on the horizon and the strong possibility for a sale at a large premium in the next year, I believe investors at today’s prices will be well rewarded.

It is certainly somewhat atypical to pitch a trucking company on VIC. In fact, by my count, this is the first trucking company to get pitched here. The reasons are obvious: the industry is incredibly cyclical, barriers to entry are minimal, and the returns on capital… well, let’s just say you won’t be finding a trucking company on the magic formula anytime soon.

So USAK isn’t exactly a Warren Buffett buy and hold forever investment. Instead, an investment in USAK is about buying a set of chronically undermanaged and underutilized assets that, at industry average margins, revenues, and multiples, will produce earnings and a stock price significantly higher than today’s price.

Background

USAK operates in three segments. The main segment, responsible for about 75% of revenues, is the trucking segment. They offer trucking services, mainly medium haul, to companies through either company owned trucks or by setting customers up with independent contractors who own their own equipment. The other segment, SCS, offers freight brokerage and rail intermodal to trucking customers. Simply put, these services help trucking customers utilize other forms of transportation to get their goods where they need to go. Intermodal, for example, offers customers the ability to utilize rail services for a piece of the shipping in order to save money.

In 2008, the company introduced their Vision for Economic Value Added (VEVA) plan. The plan called for the company to earn returns in excess of cost of capital and consistently grow EBIT in order to deliver superior shareholder returns. The company aimed to do that by focusing on shorter regional routes (<500 miles) because rail generally offers superior economics at longer distances and the continued shift to lower inventory levels with rapid replenishment in retail is driving demand in that segment.

Obviously, the shift sounds reasonable, and it’s in-line with what almost every other industry peer has pursued. However, there is a trade-off between longer and shorter routes. Longer routes will generally have lower pay per mile, but they should show higher efficiency (less empty or unpaid miles) as longer routes means less time switching from one load to the next relative to the time spent driving. Shorter routes, in contrast, get higher pay per mile but will have more unpaid miles as the trucker has to shift loads more frequently. The problem with USAK’s strategy is they managed the first part (shift to shorter routes) pretty well (average miles per week went from 2,200 in 2007-2008 to 2,000 in 2010 and 1,800 in 2011-2012) but they forgot about the whole “increased pricing” piece of the strategy. As a result, base revenue per truck per week (how much revenue a truck earns every week, excluding any fuel surcharges) went from $2,800 in 2007-2008 to $2,600-2,700 in 2010-2012.

The company made some other “interesting” strategic decisions over this time. When the market was heating up in 2005-2007, they made some big fleet investments, growing trucks from <2,200 at 2004 year end to 2,500 by 2007. However, as the market softened in 2008-09, they dramatically cut back on their investment program, and by the end of 2012 they were back to just 2,200 trucks. Their investment program, in other words, was the trucking equivalent of buying high and selling low. In addition to poorly timed expansion, USAK let their fleet age, with the average age of their trucks sitting at 32 months at the end of 2012, versus 24 months in 2008 and around 20 in the 2004-2006 time frame. 

The increase in age may not sound like a big deal, but the maintaince cost per mile goes up dramatically as a truck ages, a significant competitive disadvantage. Indeed, every other publicly traded peer has gone in the opposite direction of USAK here and has constantly modernized its fleet, leaving USAK w/ the oldest fleet among publicly traded peers.

There’s also plenty of “non-financial” evidence that points to the company being broken over the 2008-2012 time frame. Annualized driver turnover spiked to 120%+ in 2012. Having driver turnover that high is an absolute disaster for a trucking company: losing drivers reduces utilization, it costs money to hire new drivers to replace lost drivers, new drivers need training, and new drivers’ lack of experience leads to more accidents and higher insurance costs versus old drivers. As a result, the company’s safety scores plummeted way below any of their competitors. While something as soft as “safety culture” may not appeal to more quant oriented value investors, it’s important to note that proper safety and training measures are among the best ways to reduce costs in the trucking industry.

To sum it all up: USAK’s strategy heading into 2013 had effectively consisted of buying high and selling low. In addition, the company’s strategy effectively left them with higher costs and lower revenues, the fleet was in worse shape than it had been in years, and the safety culture was deteriorating.

Turnaround

Into this void stepped current CEO John Simone. John had previously been the CEO of LinkAmerica, a company with a background strikingly similar to USAK. Tenex Capital Management acquired LinkAmerica in June 2011. LinkAmerica was a struggling trucking company dealing with an aging fleet and poor financials. They hired Simone as CEO in August 2011. Simone modernized the fleet and sold LinkAmerica to Arnold Transportation by December 2012. USAK hired him in Feb. 2013 to turn the company around.

Simone immediately set upon a plan similar to the LinkAction plan. He focused on improving fuel efficiency, reducing insurance costs, and modernizing the fleet. Results have been extremely impressive: 2013 saw “across the board improvements in key operating metrics.” Particularly impressive is the company managed to improve pricing (rate per loaded mile) while simultaneously improving average length of haul. They also managed to increase seated trucks while improving productivity. Trucking companies, in general, face trade-offs between those metrics (i.e. you can choose between higher pricing or longer haul length). That the company managed to improve on all metrics at the same time goes “miles” in showing how poorly managed the company had been in 2012.

Upside

While the improvements to date are impressive, the company still has a long way to go. The trucking business is still operating at a significant operating loss, and basically every significant operating metric continues to fall significantly below competitors. In fact, the company has already disclosed a set of long term operating metrics they’d like to hit. These metrics include raising weekly revenue per truck from $2,957 to $3,200, weekly miles per truck from 2,057 to 2,200, and reducing driver turnover from 102% to 95%.

Are any of these aggressive or unrealistic? Absolutely not. In fact, most of these metrics are relatively conservative. For example, the company is targeting insurance claims at <6% of base revenues. Peer Werner is currently at 5.5% of revenues and has been in the low 5% of revenue for years. USAK’s goal of $3,200 weekly revenue per seated truck sits well below WERN’s $3,457, SWFT’s $3,366, and MRTN’s $3,465 (though, to be fair, it’s a bit above KNX’s $3,085). Every single peer has forecasted a tightening market with some pricing increases  (2-3% seems to be the norm) in 2014, so the fact the USAK’s long term revenue target per week sits below their peers 2013 numbers suggests quite a bit of conservatism.

Improvements in pricing and expense structure should result in significantly higher operating margins. The key metric in this industry is operating ratio (operating expenses net of fuel surcharge divided by base revenue). As you can probably guess given operating ratio is directly tied to profitability, USAK significantly trails every single relevant peer. In fact, only two peers (CGI and JBHT) are even close to 100 (meaning operating expenses = base revenue) and almost every single peer is at or below 90 (meaning operating expenses = 90% of revenues, or a 10% profit margin)

Simply assuming USAK hits their $3,200 weekly revenue target and manages to get their full year percent of unseated trucks to 4% (they were there in Q4), revenue from the trucking segment would come in at about $365m. With an OR of 92% (low end of their range, and still worse than most peers), operating income would come in at $29m. Add back $45m of D&A and we get EBITDA for the trucking segment of $74m. Peers are currently trading at 7.0x+ EBITDA, and historical multiples and precedent transactions are in the 5.0-6.0x range. Take the low end of that range (5x) and the trucking segment alone would be worth $370m. Take out $129m in debt and that would leave $241m left for the equity, or ~$23 per share.

However, that value doesn’t include the Strategic Capacity Solutions business. For FY2013, this segment produced $9m in operating income, up 35% over FY 2012, on $118m in revenue, up 6% over 2012. Given the asset light nature of the business, it would be pretty conservative to say this business is worth 7x EBIT. Doing so produces $63m in value, or another $6+ per share, but there’s likely significant upside to that value from continued growth and the extremely conservative multiple. I’m not claiming this is a perfect comp by any means, but you can look at the multiple something like XPO or RLGT is getting to imagine the upside here. It’s also worth pointing out that Baker Street (discussed in the activist section) was previously involved in Autoinfo, a very small broker which got bought early last year for ~7x EBIT.

Put it all together and the whole company is worth at least $29 per share with relatively conservative operating metrics and multiples. Given the recent burn from investing in turnarounds with extreme upsides on standardized metrics (see: JCP), I can understand there might be some hesitation to using that target, but I think it’s an entirely reasonable target given the company’s turnaround is well underway and it is much simpler to turn around a trucking company than something as fickle as a retailer.

Catalysts

Obviously, I think the company is attractive on its own. But I think what makes the company really attractive is the likelihood of a sale or some other value realizing transaction taking place in the very near future.

In August, Knight Transportation (KNX) bought 7% of USAK’s shares and proposed to buy USAK for $9.00 per share. Knight eventually increased their ownership stake to 12%, published a very hostile presentation supporting their bid, and criticized USAK for operating one of the oldest fleets among its publicly traded group.

To me, a merger between Knight and USAK would make a ton of sense. Knight is one of the best operators in the business, with an operating ratio consistently in the low to mid 80s, and Knight and USAK’s networks would fit each other extremely well, with significant overlap allowing for serious synergies. The question is simply one of price: Knight’s offer was obviously extremely opportunistic and gave USAK no credit for its on-going turnaround, and the board was wise to reject the offer.

USAK also felt Knight played “unfairly” by buying the company’s stock while negotiating to buy the whole thing and sought to force Knight to dispose of their shares. The two companies eventually came to a standstill agreement, with Knight holding its investment and agreeing not to make a move until the end of this year at the earliest. I feel the settlement represents the best of all worlds for shareholders: it shows Knight’s clearly still interested in making the acquisition, but it also allows USAK to continue turning around and get full credit for that turnaround in a potential bid (as well as allowing them to fully shop the company).

Even if Knight doesn’t come back with a higher bid, I believe an acquisition is inevitable for USAK. There are several reasons for the inevitability. Obviously, the CEO sold his last company about a year to his tenure, which suggests deal making comfort. USAK’s asset are clearly attractive- Knight bought up 12%of the company with an eye towards buying them out, and peer Celadon (CGI) pursued a similar hostile takeover tactic in 2011. These comps are looking to buy Knight to take advantage of the upside from the turn-around as well as to buy their drivers (there’s been a well-publicized driver shortage, which places a ceiling on these companies’ growth) and get access to USAK’s markets and route strength, particularly in the east. These peers have been clear that they continue to see the market consolidating, and almost every industry participant has recently stated that there are significant benefits to continued mergers and consolidation in the space. Of course, talk is cheap, but industry participants have backed this talk up and with plenty of significant merger activity in the past year (HTLD and SWFT have both completed big mergers recently; see “acquisition environment” for a deeper dive into this thesis).

The problem with mergers is it takes two to tango, and investors may worry that USAK will continue to sit the dance out despite repeated overtures, as it did in 2011. However, I think the risk of that is basically zero given the continued evolution of the shareholder base. In addition to KNX’s 12.4% ownership, Stone House Capital filed a 13-D and owns just under 15% (average price ~$13.50; this is the same Stone House that counts Bill Ackman as an investor and manages only $50m, so this is a significant investment for them) and Baker Street’s 13-D gives them just over 13% of USAK (average price just under $13). The combination of three 13-D filers owning 40% of the stock ensures that the board will be very active in pursuing potential deals, as they can easily be voted out if they don’t aggressively pursue anything that comes their way. In addition, the combination of Stone House and Baker Street ensures proper watch on Knight and guarantees they’ll need to pay a full and fair price before acquiring USAK.

Acquisition environment

Before wrapping this article up, it’s instructive to dive a bit further into the current acquisition environment and why it makes an acquisition of USAK even more likely.

First, the financing markets are wide open for trucking companies. Obviously that’s true for just about every industry in today’s environment, but the trucking financing market is especially hot. Both SWFT and HTLD completed acquisitions in the $200-300m range in the past six months, and each of them managed to finance the acquisition entirely with cash on hand and credit facilities with super low interest rates (SWFT at 2.2%; HTLD at L+62.5 bps (<1% currently)). In that context, it’s worth noting that both previous bidders for USAK have significant untapped credit lines and have expressed interest in doing M&A on recent conference calls: Knight has an unsecured credit line with $225m in availability and an interest rate of L+0.625% and CGI has $125m on a credit line that bears interest at less than 1%.

Second, the acquisitions in the space reveal a bit about how accretive a roll up can be in terms of synergies. Obviously synergies will be dependent on each company’s network and how much overlap they have, but we can still see how the right acquisition can drive significant synergies. HTLD identified $30m in potential synergies from its acquisition of GTI. To put that in perspective, this was a $300m acquisition and the combined company projected to have base revenue of $770m and operating income (before synergies) of $96m. HTLD announced the acquisition in early November and saw its share price rise from $14.25 per share to $17.25 per share on the back of the acquisition announcement (a market cap gain of over $250m on the announcement of a $300m acquisition!), and its share price has continued to run to over $20 today. To be fair, there were several one-time items in the HTLD deal (mainly tax related), but the pure amount of market cap value creation significantly dwarfed those one-time items. CEOs and boards pay attention to peer’s stocks rising dramatically on acquisition announcements; part of the recent boom in tech, media, and pharma M&A is certainly driven by how the stock market has responded to announced acquisitions. CEOs certainly have to be looking at the HTLD deal and imagining something similar if they buy USAK.

To wrap it all up, between the continued progress on the turn around, multiple strategic buyers, and two experienced and well respected activists, the odds are greatly in favor of USAK’s shares being materially higher 12 months from now.

Additional reading- Good article interviewing the CEO on strategy and background post Knight hostile offer. 

Catalyst